BUSINESS NEWS MARCH 7, 2019 / 12:43 PM / A MONTH AGO Exclusive: SEC scrutinizes fairness of stock exchange pricing NEW YORK (Reuters) - The U.S. Securities and Exchange Commission is investigating whether the multi-tiered pricing system used by stock exchanges favors large brokers at the expense of small ones, according to a person familiar with the matter. U.S., June 6, 2018. REUTERS/Brendan McDermid Under the current system, Wall Street banks and other massive traders get hefty rebates based on how much business they funnel to exchanges. The result of this complex and often opaque system is that big users can end up trading for free, or even get paid to trade, while small brokers pay substantial fees. Most exchange operators, including New York Stock Exchange-owner Intercontinental Exchange Inc, Nasdaq Inc and Cboe Global Markets, have embraced the system in at least some of their exchanges to help boost volumes and fatten their bottom lines. While the SEC has not launched a formal civil investigation, it is seeking information from the exchanges on the pricing system. If the SEC were to determine that the tiered structure is unfair, exchanges could be forced to simplify their pricing models, potentially costing them millions of dollars in fees. SEC spokeswoman Judith Burns declined to comment. NYSE and Nasdaq declined to comment on the SEC probe into multi-tiered pricing. Cboe said it offers different types of pricing tiers catering to all of its clients and that the tiers are the result of years of intense competition among exchanges. “At this point, we do not have plans to change our pricing schedules,” said Bryan Harkins, who co-heads Cboe’s markets division. More generally, exchanges say that fierce competition in the industry has resulted in tighter bid-ask spreads that benefit all investors. The regulatory scrutiny is part of a broader effort by the SEC under Chairman Jay Clayton to improve transparency around exchange pricing and ensure it is fair and equitable as required under the Exchange Act. “The SEC has thrown the gauntlet down,” said Chester Spatt, a finance professor at Carnegie Mellon University and a former chief economist at SEC. Tiered pricing will likely emerge as a central issue in the debate, said Spatt, who has a working paper on the topic. The regulator has also ordered exchanges to justify recent fee hikes for market data, and has mandated a pilot program to test banning rebate payments that exchanges make to brokers for liquidity-adding stock orders. ICE, Nasdaq and Cboe have filed lawsuits or appeals challenging the SEC’s authority on those two mandates. Tackling U.S. exchanges is one of the few areas where Republicans and Democrats agree. Republicans believe the current rules are anti-competitive, while Democrats worry existing exchange structures and incentives could hurt small and large investors. (For graphic comparing number of small brokers to mid- and large-sized brokers, see: tmsnrt.rs/2VKfgCw) HARD TO COMPETE Tensions between Wall Street and the exchanges, which were once member-owned, not-for-profit utilities, have risen over the past decade and a half as the bourses have become public companies. Some brokers say the exchanges have used their essential position in the market to maximize profits, often to the detriment of smaller brokers. Joe Wald, chief executive of brokerage Clearpool Group, said tiered pricing makes it harder for smaller brokers to compete for customer orders against bigger firms, which get significant discounts on trading costs. “It discriminates against smaller broker dealers who end up almost perversely subsidizing the cost of the whole exchange relationship for the largest firms,” he said. Clearpool executes more than 2 percent of U.S. stock trades on an average day, but comes nowhere near hitting the higher-volume exchange tiers, which allow the biggest brokers to reap rebates nearly 60 percent higher than those that qualify for base rates, Wald said. When factoring in rebate payments from the exchanges, five of the top 10 customers at both Nasdaq and Cboe by volume actually receive checks from the exchanges at the end of the month, net of fees, according recent comments by a Cboe executive and a Nasdaq report. PRICING PATHS The current fee schedule was approved by the SEC, and exchange pricing lists are publicly available. But they can be dozens of pages long and it is impossible to know which brokers qualify for which tiers. An analysis by RBC Capital Markets in October found at least 1,023 “pricing paths” across exchanges, made up of 3,762 variables, meaning that there are dozens of possible net prices for execution. “These 3,762 variables strongly suggest that exchange prices are tailored and offered on a bespoke basis,” the report said. Exchanges have credited pricing tiers for helping boost revenues. Bats, an exchange operator that has since been sold to Cboe, said the introduction of tiered pricing for its markets in July 2011 helped increase revenues by $14.6 million over the rest of that year. Large brokers, which include investment banks and high-frequency trading firms, can also profit from tiered pricing by offering smaller brokers that funnel their orders through them a portion of their steeper discounts, while keeping the remainder. Cboe’s Harkins said that this “sponsored access” allows smaller firms to share in the savings with big brokers. Reporting by John McCrank; Editing by Neal Templin and Meredith Mazzilli
Since every business of every type in every industry provides volume discounts, if I were the SEC this would not be a priority for me. IMO, the fragmentation of the equity and option markets has not benefited customers because they do not truly compete for business by either technology or cost. The exchanges also use their monopoly to price market data wherever they want reducing access for small players and some retail clients. E.G. A single member LLC should not be treated the same as a prop group. I would make the exchanges provide data that shows that 15 option exchanges are necessary. I would make the owners of the ECNs that offer more than 2, provide data that shows their are necessary. I would make the exchanges (SIP feeds) provide clear exceptions for small business from both higher display and non-display fees. The SEC needs to do more to protect the public by providing low cost market access for "retail" and small institutional players.
E.g. Option market 1.00x1.10. You place your bid for 10 at 1.02 on the CBOE. New market, 1.02x1.10. Now a sell order comes in. You have time and best price on your side on the CBOE. An order at Morgan Stanley to sell 50 calls gets sent to the MM they use for their DMM and they buy 50 at 1.02 on Philly, you get none. They have 14 other options exchanges to cross that trade and avoid your order. Do you think that is fair? This is an example of why fragmentation hurts retail customers. You made a better bid but did not get a fill. Bob
Isn't this called internalizing? Sounds like not very difficult to fix. I am not a fan of monopolies like CME.
No. Directing order flow to be handled by a DMM is normal business with options markets. If I'm your broker and take the other side of your trade, that is internalizing, like what IB did before they sold Timberhill. I'm a big fan of the CME model, but on some symbols they compete with ICE. This would never happen, but with options, I'd like ever order to be sent to whatever exchange you want to do business with. If not executed, have all orders moved to a central order book where every order, MM, Firm or Customer, has time order priority. That would force players to make better markets before trades and place everyone on an even playing field.
Having exclusive product like SPX solves this problem right? Though CBOE charges hefty premium for this